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Employing Your Family Members

By Scott C Turner, CPA

Hire your kids

instead of paying them an allowance!

It is quite common to see children actively involved in the family business. Even young children can perform valuable services. Many business owners, however, miss out on the major tax savings generated by actually hiring their children and paying them a fair wage for their services.

The expense is tax-deductible to you, and the income is tax-free to them. [Reg Sec 1.162-7(a) ]

The tax-free limit for dependent children was $12,000 per child per year starting in 2018, $12,200 for 2019. The amount is equal to the Standard Deduction. If a child has interest, dividends, capital gain distributions or other investment income, the Standard Deduction is slightly reduced, incurring a small amount of federal tax.

[Rev. Proc. 95-53 and IRC Section § 63(h)(2). TCJA Dec 2017 ]

{Note: For 2019, a child with investment income in excess of $2,200 is taxed at the parents’ income tax rate. See your profit consultant for assistance}

In order to qualify, the wages must be reasonable in amount, based on services actually rendered and documented as paid on a regular and consistent basis as you would an employee from any business.

Children as young as seven years old have been found to qualify as employees of the parents’ business.

[Reference Eller v. Commissioner, 77 T.C. 934 (1981) ]

And if they are family members under 18 working for a sole proprietorship, they are exempt from payroll taxes [IRC Section § 3121(b)(3)(A) and § 3306(c)(5) ] and the business is not required to withhold or to pay Social Security and Medicare taxes. [Tax Court Ruling 48 TC 439, 450 (196) in the case of Denman v. IRS Commissioner]

For incorporated business owners, your corporation will have to pay payroll tax and you do need to withhold social security/medicare from the children’s wages, but the benefits are still well worth it.

Clearly it is more advantageous to employ children through a spouse’s Schedule C (sole proprietor) business rather than through an entity reporting as a corporation for tax purposes.

In order to qualify, the wage rate has to be “reasonable and customary” within your region of the country and within your industry for the type of work being performed. And, of course, always pay your employees (children) on consistently scheduled pay dates, just like you would any other employee.

Because there is no federal or state income tax withholding, and no social security or other tax, for children under 18 the gross pay is the net pay, so there is no need to calculate a net payroll check.

Payroll Reporting

These wages must be paid and the appropriate payroll tax returns and W-2 forms filed with the IRS and Social Security Administration. If children are your only employees, you can report annually to the federal government using Form 944, 940 and W-3/W-2. However, many states require you to report quarterly.

If your spouse also works in your business, the first year you can file annually to the federal government. Thereafter, the IRS will advise you if you need to report payroll quarterly, depending on how much tax and social security/medicare is withheld. To employ an accountant to assist you should only cost a modest fee.

[Revenue Ruling 73-393]

The kids (as employees) should document what they did to earn the money, [Revenue Ruling 73-393] so have them fill out a simple “work log” with headings like:

Date they worked

Type of work performed

Amount of time spent working

Hourly rate you paid them

** Pay Attention Here **

We’re about to show you how to pay for …

The car your high-schooler wants

Designer-label clothes the kids demand

Movie and Concert tickets

A High School graduation trip

College tuition, books and supplies

Your daughter’s expensive wedding

And lots of other personal out-of-pocket expenses

ALL in PRE-TAX Dollars!

Here’s how you can do this…

The tax-deductible $12,000 or more per year Uncle Sam lets you pay your children as employees, is equivalent to more than $230.00 per week!

But, you say, “Who gives their kids a $230.00 per week allowance?”

Minimum wages are rising across the country. That could be only around 15 hours a week, or so. A teenager could handle that amount of work. For younger children, be prudent, inasmuch as the deduction applies only when you pay children for work performed.

As an example: Let’s say you come up with the tax-free limit of about $100.00 per week worth of business related “chores” for your 10 year old to do. After they turn in their “work log”, you then pay them by check.

You’ll have to open a separate checking account for them in their name with you or another guardian as custodian to deposit and cash payroll checks. Of course, you will deposit every paycheck into that account.

The bank will require it to be a “joint account” with you, since they are minors. .

Reader Alert!

Here is Where It Gets REALLY Interesting…

The law requires you to pay them the wage they earned, in order for you to be able to deduct the amount as a business expense. You may pay them weekly, semi-monthly or monthly, just be sure to have a consistent pay day.

These funds can now be used in a variety of ways so long as they are for the benefit of your child. The only other specific restriction is that this money cannot be used for your child’s lodging or meals.

[Rev. Rule 73-393]

So, here’s an idea, you simply tell your child:

“I will withdraw $10 (for example) out of each week’s pay for you to spend any way you wish, however, the other $90.00 will stay in the (interest-bearing) account to be used by you to pay for your________.”

Fill in the blank with “car”, “graduation trip”, “wedding”, whatever you like.

There’s another practical benefit to this strategy that is at least as important as the tax benefits. Your child/children will begin learning the value of a dollar. Imagine being at the mall to buy a new pair of shoes. The child has to decide whether he or she wants the $150 designer-label brand or the $45 generic brand – knowing that whatever they have left in their checking/savings account will be theirs someday, to pay for their car, trip, college, wedding, etc.

Isn’t that a great tax-savings strategy and a great learning opportunity for your children?

Next - Hire Your SPOUSE,

So You Can Write Off Medical

“Out-of-Pocket” Expenses for YOURSELF!

This applies to sole proprietor entities only. When your spouse is an employee of your home-business, he/she is eligible for “benefits” from his/her employer (that’s you), and those benefits are deductible as business expenses.

[IRC Section § 162(a)]

You establish this health care benefit as company policy simply by implementing it:

Any and all employees and their family members (again, that includes YOU) will be reimbursed (by the business) for all medical-related expenses not covered under any other insurance plan he/she may have under another employer.

“Any and all employees” means your spouse and your children, “and all members of their family” includes YOU.

A Word of Caution:

Only establish this company policy if your business will be hiring only your own family members. If you establish this policy and then hire non-family members, you will be required to offer this benefit to them as well, and that could defeat the purpose.

So What Just Happened?

You just set into place a strategy for legally tax-deducting all annual insurance plan deductibles, co-pays for doctor visits, prescription drugs, and non-covered expenses like braces, glasses, contact lenses, dental work, and possibly even cosmetic surgery.

[Reg Sec 71-588; Plr. 9409006]

No minimum thresholds apply; every single dollar is tax-deductible by the business as an employee benefit cost.

It is important that this “policy” be established in writing, as a legal document and that the benefit is reasonable in relation to the level of services provided by the employee to your business. In Appendix C to this system you will find a sample fill-in-the-blanks “Self-Insured Medical Reimbursement Plan”, which you may feel free to adopt or adapt, if you wish. [Reg Sec 1.105-5(a)]

A Word About the Level of Your Spouse’s Wages

A sole practitioner (Schedule C taxpayer) is not required to pay Unemployment Taxes on the employment of a spouse; however the business is required to pay Social Security and Medicare payroll taxes on adult family-member employees.

Since those taxes are calculated based on a percentage of the employee’s wages, the lower the wage level, the lower the payroll taxes will be. Even if you employ your spouse at “minimum wage”, you qualify to use this medical expense reimbursement tax strategy, so long as this benefit is reasonable in relation to the level of services provided by your spouse.

[IRC Section § 3306(c)(5); IRS Publication 15, and IRS Circular E all apply]

However, from a tax planning standpoint, you won’t incur a greater social security/medicare cost by employing your spouse at any wage amount from a profitable sole proprietor business, unless your net income prior to paying those wages exceeds the annual social security threshold ($132,000 in 2018).

And if that is the case, you should not be operating as a sole proprietor.

Corporate versus Sole Proprietor

Wages of Family Members

A business owner operating out of a corporation likely has several additional

factors to consider. To maximize tax savings, it is important to follow the

guidance of a Trusted Business Expert implementing the “S Corporation and

Individual Tax Strategy Plan”.

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